“What If” Looks More Like “What Will Be”

Bill Ehrman

23 Oct 2017

Global stock markets have risen this year for all of the right reasons: global economic growth has accelerated without inflationary pressures; monetary authorities remain accommodative creating more capital than needed by the economy and thereby supporting financial assets; interest rates have remained historically low for this stage in a global recovery although the yield curve has finally begun to steepen; finally, corporate profit gains are rising due to volume growth combined with continued cost containment.

It is looking realistic that Trump will be able to pass the cornerstone of his pro-growth, pro-business agenda, which is tax reform, this year. Both House and Budget have passed 2018 budgets and made procedural changes to expedite the regulatory process for tax reform. “What if” now looks like “what will be.”

While it remains questionable how much added growth will come longer term by reducing corporate taxes, it is a fact that reducing the statutory rate from 35% (real rate closer to 27%) to 20% will boost S & P reported earnings by over 11%. It possibly could be retroactive to the beginning of 2017. In addition, there will be a deal to repatriate over $3 trillion in foreign cash. How corporations decide to use it may be questionable, but nevertheless it will be positive for corporate America and investors one way or another. While we do expect to see individual tax reform also as part of the package, we doubt that it will add much to economic growth in and of itself but it should help the middle class somewhat appeasing the Democrats. Job creation will come from business tax reform as well as companies, both foreign and domestic, adding plants in the United States due to the tax code changes.

The key event last week was the increasing prospect of tax reform this year but let’s also view what occurred around the globe, which would support or detract from our global economic perspective that non-inflationary growth is accelerating and with it corporate profits gains:

1.) It is clear that what is happening in the United States is pivotal to our outlook for investing over the next year or two. We expect growth to accelerate here as we move through the fourth quarter into 2018 as both corporations and individuals get more confident that tax reform is really here. Let’s review what occurred last week that creates the foundation from which growth will accelerate into 2018: homebuilder sentiment rose to a 6-month high of 68 while housing starts actually fell 4.7% impacted by the hurricanes; industrial output accelerated 0.3% in September despite the impact of the hurricanes and utilization rates rose to only 76% which is still non-inflationary; leading indicators actually fell 0.2% while coincident indicators increased 0.1% and the Atlantic Fed forecast stands at 2.7% for the third quarter which is better than we had assumed earlier due to the hurricanes.

2.) The Fed Beige Book came out Wednesday and it supported relatively strong economic growth in September and October despite the hurricanes. Officials commented that inflation continues to surprise on the downside but they still believe that this will change moving into 2018. We disagree! Finally it appears that Trump will announce his choice for a new Fed head and we believe that Powell will get the nod. He will be good for financial assets.

3.) China held its twice a decade Congress last week and there were no real surprises: President Xi Jinping was elected for another five years; he made several changes within the leadership team increasing his power and influence; he promised to open the service sector more to foreign companies; reduce excess industrial capacity while reducing pollution: and changes in the ownership position in several key companies increasing the government’s influence.

It was also reported last week that China’s industrial output rose 6.6% in September while fixed asset investment expanded 7.5%. Finally third-quarter growth was reported at 6.8% in the third quarter with retail sales jumping 10.3%. China will easily beat its 6.5% target for growth this year and will most likely maintain this pace into 2018 too. China remains at the top of our list for long-term investing emphasizing the consumer sector and technology as it receives increased government support.

4.) Bank of Japan Governor Kuroda said last week that the central bank would continue its policy of aggressive ease in an effort to boost inflation as it appears that its target of 2% inflation is way off in the future. All good!

5.) Growth in the Eurozone continues to surprise on the upside as exports rose by 2.5% in August from July despite a strong currency. Here, too, we expect the ECB to maintain its overly accommodative stance until inflation moves closer to the 2.0% level, which may be a long way off.

6.) The disruptors continue to pop up everywhere forcing major changes for the established players. For instance, Netflix is upping its spending on content to $8 billion hurting broadcasters like ABC, CBS and NBC. Nordstrom suspended its effort to go private, as lenders wanted too high an interest rate to fund the transaction noting that the box retailers are in a declining state.

Paix et Prospérité has continued to outperform all market indices since our inception 3 years ago as we have stayed focused on looking through the windshield searching for change that will have both positive and negative impacts on the financial markets and specific investments. It is clear that the Republican Party has capitulated at long last understanding that if they do not pass at least parts of Trump’s pro-growth, pro-business agenda that they risk losing their own seats and control over Congress. Both the far right Republican Conservatives and the more liberal Republicans voted in the Senate for the 2018 budget and procedure change that increases the probability of passing tax reform this year. How long have we been writing that the path of least resistance for the markets was up supported by the global macro picture and “what if” tax reform was passed? Now we have it! And hence the next leg up catching most institutional investors under-invested as we move through the fourth quarter.

We continue to emphasize the financials, mainly the largest global banks like Bank America, Citi and JP Morgan; the global industrials like GE, HON, FTV, IR, EMR and UTX; low cost industrial commodity companies like BHP and RIO and U.S low cost steel and aluminum companies like AA and NUE which will benefit from a large reduction in China’s capacity; technology at a fair price such as CSCO, MSFT, NVDA and ORCL; and special situations like DWDP, HUN, FMC and PX.

We want to thank our investors who have been patient letting our investment view unfold as it takes time. The benefits to investing over trading and active management over passive management are clear now to all who are with us and have stayed attentive to our weekly pieces.

So remember to review all the facts; pause, reflect and consider mindset shifts; understand and be willing to adjust your capital allocation and risk controls; do independent research and…